Long VIPS at current price of $11. Market is overly negative on VIPS despite near-term earnings misses. Nothing broken about the business model, management confident about 2017. Sentiment for Chinese ADRS has shifted from extreme optimism to extreme pessimism. VIPS down 66% from 2015 high of $30. Market tends to over-react with regard to Chinese ADRs on both ends, with extended periods of overvaluation and undervaluation. We are in the latter.

VIPS trades at 12x 2018 P/E on expected 20-30% EPS CAGR, and 7x rolling 2018 EV/EBITDA, a historical low. There is room in China e-commerce for multiple players and VIPS’s leading discount/flash-sales model, strong relationships with suppliers, and logistics capabilities should still have substantial TAM to grow into. Nobody knows what’s going to happen in 3-5 years, but any positive beat in 2017, buybacks, improving sentiment, and other catalysts can easily propel VIPS back into the $15-20/ADS territory, for a 50-100% return in less than a year.

There are rumors that VIPS is a takeout target given its net cash balance sheet and vertical category expertise, but rumors have been swirling for a long time so I won’t speculate on this.

Business Model:

VIPS was founded in Guangzhou in Dec 2008 by Eric Shen (Wenzhou native) and Xiaobo Hong (Vice Chairman). Eric was a born entrepreneur with a decade of experience in electronics products distribution before one day he saw his wife fixated on a French flash-sales site called Vente Privee in 2008. He realized that he would copy VP’s model to China where the market demand was huge. Having raised an initial 30 million RMB, VIPS set up shop in Guangzhou in 2008.

VIPS is a flash sales website selling discounted apparel, cosmetics, shoes, bags, home accessories, baby products, and other products via：http://www.vip.com/. It is basically an online version of TJX Maxx. China’s offline retail network is far more fragmented than the USA’s, thus giving e-commerce players like VIPS a big opportunity to rapidly expand coverage to entire China.

I won’t write a book about the company’s background as readers can find plenty of background information about VIPS online.

VIPS went public in March 2012, the worst time for Chinese IPOs in the USA given the reverse-merger scandals back then. Goldman priced the IPO at around $1/ADR but the offering was under-subscribed. Offering price ended up around $0.6, and stock traded as low as $0.4 at some point (all adjusted for 10 for 1 split in 2014). VIPS achieved full net profitability starting 2013 and the stock skyrocketed to a high of $30 in 2015.

2015 was a tough year. The huge China A-share bubble, short-seller attack on VIPS, and a few minor earnings misses killed VIPS. 2016 was no better, despite VIPS actually reporting a set of solid numbers. Market expectations were too high. The surprise election of Trump and fear of RMB currency depreciation continues to hurt sentiment about VIP and ADRS in general. Buzz about Alibaba and JD.com also took attention away from VIPS. VIPS fell 2/3 from its $30 high, trading at $11 today despite not-so-bad 2016 9M results (slight miss in 3Q16).

Valuation:

While VIPS might have been overvalued back in 2015, it is in value territory today.

Most investors don’t fully understand VIPS’s moat and culture. They are still creeped out by debunked short reports saying VIPS is a fraud. It’s not. Plenty of people in China shop on VIPS. Given fraud accusations have been going on since 2009, you would think Muddy Waters or some short seller would have dug out all skeletons by now. But so far, nothing. Eric Shen is extremely low profile, doesn’t do interviews, and doesn’t attend conferences. He is the anti-Jack Ma. Some say that Eric Shen is the only person in China that Jack Ma wants to meet so badly but cannot. Eric owns about 15% of VIPS stock.

Eric Shen is notoriously obsessed with customer service. When VIPS started in 2008, there were times when customers placed an order for a product only to find that product having sold out minutes before to another buyer. To honor these commitments, VIPS would actually buy another product at full price and ship to customer at 60%-80% discount, taking a loss to satisfy a customer’s orders. There are complaints of poor product quality from VIPS but that isn’t the same as VIPS selling fake products. The company is 100% focused on execution and growth. It does not try to manage the stock price. This discipline reminds me of Amazon’s religious devotion to customer service, although VIPS is not as innovative nor dominant as AMZN. But that’s ok, VIPS is cheap.

Active users in 3Q16 reached almost 45M, having grown at a 50% CAGR for the past 3-4 years. VIPS is a niche player, focusing on apparel and related categories only rather than everything (unlike JD.com). At 40-50M active users, it is much smaller than JD (200-300M active users) and BABA (>400M users).

The average customer orders 5 times a year, average order size RMB 200 ($29). These are not expensive items, but discount, fashionable apparel, shoes, bags, baby products, and cosmetics. Unlike BABA or JD’s 3P business, VIP stores products in its own warehouses on consignment and ships them to the customer directly. However, for items that it doesn’t sell, it can return them to the supplier.

Customers are mostly working class age females ranging from 20 to 50, and sales are spread evenly between Tier 1 & 2 (~50%) and lower tier cities (~50%). Buyers are part of the “working class” (工作族) in China and earn on average 60K RMB ($8K) per annum. With 5 orders of RMB 200/order, average customer spends about 1,000 RMB on VIPS, 2% of annual salary. This has upside.

The company has an army of 1,600 buyers whom it hires from other retailers, leading fashion brands, and fashion journals. It hires people who understands fashion sense and can shift through piles of unsold inventory at other retailers to identify products that will be easy to sell. Of the RMB 40B revenue in 2015, 39.4B (98%) was from VIP’s direct 1P model. The remaining 2% come from advertising fees, fees from 3P transactions, and fees from 3P brands using VIPS logistics).

The three largest categories are apparel (35% of rev), shoes/bags (14%), and cosmetics (13%) – total of 62% of revenues. Smaller categories include sports-wear, home accessories, and toys and baby products. Almost all of VIPS products cater to the female buyer, although new customers in recent quarters have been both male and female. 65% of revenue come from inventory clearance-related products, and the remaining 35% come from “in-season” or custom-made merchandise. In the past few years, VIPS has gradually increased the proportion of in-season and tailored merchandise as a result of it’s deeper relationships with brand partners.

Per 2016 consensus, China has 411 million females between 15 and 54 years of age – VIPS’s target audience.[1] I assume 80% of them access online shopping via mobile (82% of VIPS orders are via mobile) or PC. That’s 329M users. With estimated 50M users by 2016, VIPS has about 15% of the females in its core addressable age group.

User spending metrics have been pretty consistent since the company’s IPO. Growth is driven by increase in active members, as spending per order (200 RMB) and average number of orders/active member (5/year) remains fairly consistent. As of 3Q16, active members increased 43% yoy. Consistent with that trend, I expect total active customers for 2016 to increase 40% to 51M, and active members to CAGR at 23% to 2020. By 2020, I forecast VIPS to have about 102M customers, or about 27% of the addressable 15-54 female online shopper population by then.

VIPS is starting to acquire younger customers, post-90s, who tend to have slightly lower spending power. I take that into account by decreasing the average order size by single digit % for a few years out and keeping the outer years flat. I also run scenarios reducing order frequency.

On the competition front, JD is probably VIPS’s closest competitor. JD started its “flash sales” business in late 2014, so from the perspective of building relationships with upstream brands, optimizing purchasing decisions, and managing an extremely fast, unpredictable inventory turnover model, JD is lagging behind VIPS. However, JD does benefit from its enormous logistics network and overall large scale. However, JD is currently more focused on other areas such as fast-moving consumer goods (integrating the Yi Hao Dian acquisition), cold storage, managing its 3P platform, and expansion of logistics centers to rural places. I met with JD management in summer 2016 and it didn’t sound like flash sales was a huge priority for JD. It’s worth following, but in any case I think the market is large enough for both VIPS and JD to grow.

Overall, I forecast revenues to compound at 15-20% range (depending on assumptions) until at least 2020. Even then, VIPS will only have <1/3 of the total addressable female market (I make no assumptions about male customer capture), which I think is easily doable if the company executes as it has done historically.

Core part of being able to grow rapidly is having enough variety at the right price. VIPS generally manages to a blended gross profit margin of 23-25%, which has been quite stable over the past several years (and quarters). VIPS relies on its core team of buyers to build relationships with brand partners, retailers, and other inventory sources. These relationships are not easily replicable, hence VIPS’s moat. It is very similar to the moat at TJX or Dollar Tree – anyone else who wants to do flash sales at VIPS’s level has to hire a team of 1,600 of the brightest buyers and set up partnerships with over 8,500 brands (of which 1,600 sell exclusively to VIPS). The total number of brand partners grew from 1,075 in 2011 to over 10,000 at end of 3Q16, of which ~4,500 brand partners form a majority of the sales (remaining are thousands of small, independent brands). Revenue per brand partner has actually increased from just around $2M to ~5M in 2015 – meaning VIPS is increasing quality of partnership with each brand as well.

Based on TAM-analysis for key categories, I find that VIPS has huge growth potential and can grow at robust rates for at least another 8-10 years. See the chart below for my estimates of VIP’s penetration into each e-commerce product category. The highest penetration seems to be in cosmetics, home furnishing, and footwear, where VIPS has about 10% of the e-commerce market, whereas its core apparel category it is <5% penetration in e-commerce apparel, and mom & baby category is even less at about 2%. The key idea is that this data meshes well with VIPS management’s belief that VIPS has a single digit market share in key retail closeout categories in China and that the closeout business favors scale, making the business get “easier” as it gets larger. Many small brands want a single buyer to purchase all of its unsold inventory, and prefer a buyer like VIPS.

About 5% of VIPS’s total GMV (same as retail sales for 1P) come from cross-border merchandise. VIPS started its cross-border business in late 2015 by partnering with overseas suppliers to bring coveted products into China via flash-sales model. Management has highlighted this areas as a growth driver going forward but it will probably be too small to move the needle for now. I assume the company purchases to a 23-25% gross profit margin for overseas sales as well. Management has guided that both inventory-clearance, in-season, and tailored products share similar gross profit margin of 23-25%. Margin fluctuations on a quarterly basis is mostly based on seasonal promotions (such as 11.11, 12.8 – VIPS founding date, summer clearances, etc…).

Gross margin for the remaining 2% of sales related to advertising, commission, and logistics service fees, I assume to be 70%. However, changing this assumptions doesn’t move the needle much.

On 2Q16 earnings call, management said “compared to the 400 million users in China, obviously we still have a very tiny percentage of that market share.” “To have more than 100 million active users, we’d probably need some time, but obviously, we think that would be the first milestone to hit … Eric is pretty confident, pretty optimistic in terms of where we can grow to in the future.” (~Millicent Tu). With estimated 50M active users for 2015, I think the 100 million user target is achievable. Achieving 100M users by 2020 (in 5 year) means 15-20% user growth per annum, and 100M users by 2020 is yet only 27% of my estimated population females ages 15-54 (371M, of which 85% shop online). Obviously this is an important metric to track but the numbers don’t sound unreasonable.

VIPS may even have a bit of counter-cyclical element. If the Chinese retail spending slows down tremendously that would mean more inventory for VIPS to help clear. Discount retailers tend to outperform during economic slowdowns, as can be seen from the stellar performances of USA closeout retailers from 2008 to 2013.

The four major expense buckets are fulfillment, marketing, tech, and G&A expenses.

Fulfillment: VIPS has followed JD’s footsteps in building its own warehouses and taking control of the logistics network. For most of its products, VIPS requires suppliers to store inventory in VIPS’s warehouses to ensure fast delivery upon sale (VIPS doesn’t take ownership of such inventory until the sale). VIPS’s flash sales model, coupled with Chinese consumer’s strong desire to get the product quickly, means that VIPS’s warehouse and delivery management has to be extremely efficient (customers want products within 2 days of placing order). By 3Q16, about 90% of VIPS’s orders were fulfilled by its in-house and invested last-mile delivery capabilities, with the remaining orders for 3rd party logistics companies. The company has logistics hubs in Guangdong, Jiangsu, Sichuan, Hubei provinces as well as in Tianjin. Additionally, company also leases bonded warehouses for growth of cross-border business.

Having owned warehouses decreases fulfillment expense as % of revenue but eats up capex. VIPS’s fulfillment expense has declined from 14% of sales in 2012 to 9% in 2015. Year-to-date 2016, fulfillment expense has continued to fall to 8.7% of sales. On a per-order basis, fulfillment costs have declined from about RMB 22 in 2013 to RMB 18 in 2015. Going forward, despite the company’s promises of reductions in rental costs, self-build warehouses, and increased efficiency in fulfillment (via automation), I keep fulfillment cost/order flat at 18 RMB/order and rental expense at 0.5% of sales, for conservatism. The lower order value (post-90s new users tend to spend a bit less) may also offset some of the increased in fulfillment efficiency. I expect fulfillment expense to be 8-9% of sales going forward.

For comparison, JD’s fulfillment cost as % of GMV is about 3-4%, about 1/3 of VIPS. That’s mainly because JD builds its own network of 200+ distribution centers across China and pays minimum rental expense. Moreover, because of its larger size, it is able to better amortize its fulfillment expenses (in a large part fixed) over a larger number of total orders. I don’t expect VIPS to reach JD’s fulfillment efficiency in the future due to these structural differences.

Marketing expense is the second largest cost bucket for VIPS. It has declined slightly over the past few years from 7% of VIPS revenue to about 5% currently. Recently in 2015, marketing expenses picked up slightly as VIPS is spending more advertising dollars in social media, network TV, and online video to capture the post-80s, 90s and millennial customers, who currently spend less, have lower stickiness, but who’s spending power is expected to go up with time. I personally have seen VIPS become more aggressive with advertising in several Chinese TV shows, including the 2016 blockbuster “Ode to Joy”. I don’t expect leverage at all in marketing expense as the company is aiming to reinvest all incremental profit into marketing to drive topline growth, as CFO Donghao Yang said on the 2Q16 earnings call. JD’s marketing expense is 2% of GMV but that’s because JD is much larger in scale and can leverage its expenses better than VIPS can.

I expect tech & content expense to remain 2.9-3% of sales going forward as VIPS will need constantly renovate its IT management systems. The company opened an R&D center in San Jose in 2014 to help analyze big data. JD’s tech & content expense is <1% of GMV because of its larger scale and better expense leverage.

G&A expense has been steady at around 3-4% of sales for VIPS, although I expect a slight uptick in 2016 due to VIPS’s rollout of its internet finance business (for customers and suppliers), although going forward this expense bucket should benefit from some leverage as well.

Capex has surged since 2014 since VIPS started building its own warehouses. Prior to 2014, capex was mainly used for leasehold improvements. Starting 2014, around 80% of capex went to building own fulfillment warehouses, capabilities, and infrastructure. 10% of capex is used to enhance IT systems and website, and 10% for other corporate purposes.

VIP’s owned warehouse space was 500K square meters in 2014, increased to 1 million sqm in 2015, and should increase to 2 million sqm in 2016. I understand that many short-seller reports (probably have been debunked already) cite VIPS’s capex and massive increase in warehouse space as specious, but many additional sell side reports came out later 2015 summarizing visits to the warehouses and found nothing out of the ordinary. I have not personally visited VIPS’s warehouses but I will trust that enough accusations and investigations on VIPS’s capex have been made that if something were really suspicious we would know about it already.

Capex was RMB 2.2 billion in 2015, about 6% of sales. I assume another 2.2B in capex for 2016 (in line with consensus) and similar levels of capex until 2019, then capex declining to 2% of sales for the outer years. JD spent RMB 5B+ in capex in 2015, so VIPS is spending about 40% of JD’s level. These numbers are consistent with VIPS’ goal of following in JD’s footsteps and building its own warehouses, upgrading current storage capacity, implementing more automation and sorting, and other changes.

Starting in 2016, VIPS started its own consumer “internet financing” business aimed at using its balance sheet to extend credit to customers. VIPS also extends credit to suppliers and has done so for 3 years. JD and BABA have had their own consumer financing units for years now so VIPS is trying to follow their footsteps. VIPS has said many times that the aim of the internet financing business is to help its core retail business. By extending credit to customers, VIPS can increase average revenue per customer by 30%. Via supplier financing, VIPS increases the quality of its partnerships with suppliers to capture more market share. Consumer financing is currently non-profitable but default rates are extremely low (between 0.2% and 0.5%). VIPS currently charges customers no interest for these short-term loans, in order to capture as many customers as it can. VIPS charges about 8-9% annual interest to suppliers. In the future, VIPS does plan to charge interest for consumer loans as well.

As of Sept 30, 2016, the total outstanding balance for consumer financing was RMB 1.47B, and RMB 525M for supplier financing. These numbers are still very small compared to the scale of VIPS’s overall operations, but VIPS has stepped up G&A spending to hire more staff to manage risk related to its financing business. Unlike JD, VIPS has no current plans to deconsolidate its financing business. The financing business does have a moderate impact on cash from operating activities but can be easily added back.

According to my “conservative estimates”, I expect VIPS revenue and EBITDA to compound at 22% CAGR from 2015 to 2020. Active customers will compound at 24% per annum over the same period to reach 107M by 2020 (30% of addressable online 15-54 aged females, 85% internet penetration rate). I expect gross profit margins to remain flat at around 24%, and minimum operating expense leverage. Based on my EBITDA and cash flow estimates, which are 20-30% lower than consensus EBITDA and cash flow projections for 2016-2019, VIPS trades at 10x 2018 rolling EV/EBITDA and 7.4x 2019 rolling EV/EBITDA, on a yet still strong 20% EBITDA growth profile. I expect core EBITDA margin to reach 6-7% in 2020 and possibly even higher beyond 2020 (TJX and ROST have mid-teens EBITDA margins). It’s actually NOT a good idea for VIPS to get its EBITDA margins too high because that would invite competition.

If you believe that VIPS can continue its strong operational performance and get slight improvement on operating and EBITDA margins by improving fulfillment, tech, marketing and G&A expense efficiency, then you get closer to consensus figures, which projects EBITDA compounding at 28% annually from 2015 to 2019. On those figures, VIPS is currently at 8x 2018 EBITDA and 7x 2019 EBITDA, a historical low.

Cash flow conversion from EBITDA is very strong due to the company’s negative working capital cycle – it receives payments from customers almost immediately and takes about 30-40 days to pay suppliers. This is similar to JD and all larger e-commerce platforms. Cash from operating activities has been 1-1.5x net income but heightened capex levels should eat up a portion of that from 2016-2019 as VIPS continues to build warehouse space. For simplicity, I give VIPS no benefit of the doubt and assume that self-owned warehouse capex is actually maintenance capex in order to protect its competitive position. Thus, I keep capex at elevated 2.5% of sales forever into perpetuity (we know 80% of capex seems to be growth capex, so this is conservative).

Net cash is 2% of market cap, and VIPS should continue to generate a high-teens ROIC (at least) given solid growth and margins. Given the stock price decline, VIPS spent RMB 650M ($100M USD) on share repurchases in late 2015, at average price of $16.14/ADS (46% higher than current price). That amounted to about 1% of the market cap, not too significant, but a positive signal nonetheless.

Using a 10% WACC, RMB / USD at 6.9, and 2% terminal growth, my DCF yields $16/ADS price target, 46% upside. A sensitivity analysis is presented above. Nobody knows the future for sure, so maybe 3-5 year forecasts are useless. But my gut feeling is that expectations for VIPS have been reset from extremely high standards to very low standards. A reversion to the mean can take VIPS easily back to $20, although I don’t expect another $30 anytime soon. None of my projections give any value to the internet financing business because it is too small.

All it takes is 1 or 2 quarters of strong user growth, a good beat, or strong guidance to get the stock back to $15 or so. Despite competition from other e-commerce companies, I think VIPS is a strong player that really understands its niche. The balance sheet is solid and it generates enough cash for increased buybacks or deleveraging. At $6B market cap, it could be a takeout target by larger players like JD or Tencent as well, given general consolidation sentiment in Chinese internet space of late. I believe more good things can happen than bad at the current valuation, and the market isn’t pricing the positive scenario of strong user growth, per user spending, and margin improvements if VIPS continues to execute. The market is big enough for VIPS to grow much larger.